Chapter 12



Chapter 12

FOREIGN CURRENCY CONCEPTS AND TRANSACTIONS

Answers to Questions

1 A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency.

2 Direct quotation: 1.20/1 = $1.20

Indirect quotation: 1/1.20 = .83 euros per dollar

3 Official or fixed rates are set by a government and do not change as a result of changes in world currency markets. Free or floating exchange rates are those that reflect fluctuating market prices for currency based on supply and demand factors in world currency markets. The United States changed from fixed to floating (free) exchange rates in 1971. But the U.S. dollar is sometimes described as a “filthy float” because the United States has frequently engaged in currency transactions to support or weaken the dollar against other currencies. Such action is taken for economic reasons, such as to make U.S. goods more competitive in world markets. Both Japan and Germany have engaged in currency transactions in an attempt to support the U.S. dollar. In February 1987, the United States and six other industrial nations (the Group of 7 or G-7) entered the Louvre accord to cooperate on economic and monetary policies in support of agreed upon exchange rate levels.

4 Spot rates are the exchange rates for immediate delivery of currencies exchanged. The current rate for foreign currency transactions is the spot rate in effect for immediate settlement of the amounts denominated in foreign currency at the balance sheet date. Historical rates are the rates that were in effect on the date that a particular event or transaction occurred. Spot rates could be fixed rates if the currency was a fixed rate currency as determined by the government issuing the currency.

5 The transaction is a foreign transaction because it involves import activities, but it is not a foreign currency transaction for the U.S. firm because it is denominated in local currency. It is a foreign currency transaction for the Japanese company.

6 At the transaction date, assets and liabilities denominated in foreign currency are translated into dollars by use of the exchange rate in effect at that date, and they are recorded at that amount.

At the balance sheet date, cash and amounts owed by or to the enterprise that are denominated in foreign currency are adjusted to reflect the current rate. Assets carried at market whose current market price is stated in a foreign currency are adjusted to the equivalent dollar market price at the balance sheet date.

7 Exchange gains and losses occur because of changes in the exchange rates between the transaction date and the date of settlement. Both exchange gains and exchange losses can occur in either foreign import activities or foreign export activities. The statement is erroneous.

8 Exchange gains and losses on foreign currency transactions are reflected in income in the period in which the exchange rate changes except for hedges of an identifiable foreign currency commitment where deferral is possible if certain requirements are met. Also hedges of a net investment in a foreign entity are treated as equity adjustments from translation. Intercompany foreign currency transactions of a long-term nature are also treated as equity adjustments.

9 There will be a $20 exchange loss in the period of purchase and a $10 exchange gain in the period of settlement:

| |Billing date | | |

| | Purchases |$1,450 | |

| | Accounts payable (fc) | |$1,450 |

| |Year-end adjustment | | |

| | Exchange loss |$ 20 | |

| | Accounts payable (fc) | |$ 20 |

| |Settlement date | | |

| | Accounts payable (fc) |$1,470 | |

| | Cash | |$1,460 |

| | Exchange gain | | 10 |

10 Derivative is the name given to a broad range of financial securities. Their common characteristic is that the derivative contract’s value to the investor is directly related to fluctuations in price, rate, or some other variable that underlies it. Interest rate, foreign currency exchange rate, commodity prices and stock prices are common types of prices and rate risks that companies hedge.

11 Hedge accounting refers to accounting designed to record changes in the value of the hedged item and the hedging instrument in the same accounting period. This enhances transparency because the hedged item and hedging instrument accounting are linked. Prior to hedge accounting, the financial statement effect of the hedged item and hedging instrument were not linked. Since companies enter into hedges to mitigate risks, the accounting should reflect the effect of this strategy and should clearly communicate the strategy. The accounting and footnote disclosures required for derivatives attempt to do this.

12 An option is a contract that allows the holder to buy or sell a security at a particular date. The holder is not obligated to buy or sell the security. They may allow the contract to expire. Typically, the holder must pay an upfront fee to the writer of the option.

A forward contract and futures contract are similar because both sides of the contract are obligated to perform. A forward contract is negotiated between two parties, they agree upon delivering a certain quantity of goods or currency at a specific date in the future. Many allow net settlement which means the “winner” of the contract receives cash consideration for the difference between the market price of the commodity and the contracted amount on the date the contract expires. The initial amount exchanged at the date the contract is entered into is negligible.

A futures contract is traded on a market. The amount of commodity to be exchanged and the date of delivery are standardized. The futures rate is determined by the market at the date the contract is entered into. These contracts are settled daily.

13 Hedge effectiveness involves assessing how well the hedge mitigates the gains or losses of the asset, liability and/or anticipated transaction that it is entered into to mitigate.

The most common approaches to determining hedge effectiveness are critical term analysis and statistical analysis.

Under critical term analysis, the nature of the underlying variable, the notional amount of the derivative and the item being hedged, the delivery date of the derivative and the settlement date for the item being hedged are examined. If the critical terms of the derivative and the hedged item are identical, then an effective hedge is assumed.

A statistical approach is used if critical terms don’t match. One such approach involves comparing the correlation between changes in the price of the item being hedged and the derivative. While the FASB does not specify a specific benchmark correlation coefficient, correlations of between 80% and 125% are considered to be highly effective. Outside of these ranges, the hedge would not be considered highly effective.

14 Under a firm purchase or sales commitment, if the hedge is considered to be effective, then it would qualify as a fair value hedge.

15 A company that has an existing loan that involves a variable or floating interest rate enters into a pay-fixed, receive variable swap. The company is swapping its variable interest rate payments for fixed ones. These contracts are typically settled net. For example, if the fixed rate agreed upon is 10% for the term of the swap agreement and in one year the variable rate is 9%, then the company with the variable rate loan must pay the difference in rates multiplied by the notional amount of the loan to the other party. If the variable rate is 12%, then the company will receive the difference in rates multiplied by the notional amount of the loan. Regardless of the movement in interest rates over the term of the swap, the company will pay the fixed rate, net. This type of swap is aimed at reducing the variability in cash flows related to the debt therefore it is designated as a cash flow hedge.

16 A receive fixed, pay variable swap is entered into if a company has an existing loan that involves a fixed interest rate and desires to swap those fixed payments for variable payments. For example, a company has a loan with an 8% fixed rate and enters into a swap arrangement so that it will pay LIBOR + 1%. If the variable rate for a year is 9%, then the company will pay 1% multiplied by the notional amount as well as the 8% for the loan. Thus, the company has paid 9%, the floating rate.

If the variable rate is 6% (5% LIBOR + 1%), then the company will pay 8% on the loan, but will receive 2% related to the swap. Thus, the company will pay 6%, the floating rate.

This type of swap is aimed at reducing the variability in the fair value of the underlying loan therefore it is designated as a fair value hedge.

17 Fair value hedge accounting is used when the company is attempting to reduce the price risk of an existing asset/liability or firm purchase/sale commitment. Cash flow hedge accounting is appropriate when the company is attempting to reduce the variability in cash flows thus it is appropriate when hedging anticipated purchases and sales.

Under certain circumstances, hedges of existing foreign currency denominated receivables and payables are accounted for as cash flow hedges instead of fair value hedges. See question 18’s solution for these cases.

18 Cash flow hedge accounting can be used when hedging recognized currency denominated assets and liabilities if the variability of cash flows is completely eliminated by the hedge. This criterion is generally met if all of the critical terms of the hedged item and the hedge match such as the settlement date, currency type and currency amounts. If these don’t match then it must be accounted for as a fair value hedge.

The key difference between this situation and the more general cash flow hedge case is that an existing asset or liability is being accounted for here. Under the more general case, the recognition of gains and losses is deferred because an anticipated transaction is being hedged.

The foreign currency asset or liability is marked to fair value at year-end and the resulting gain or loss account is recognized, however, the gain or loss is offset by reclassifying an equal amount from other comprehensive income. Thus, the asset and liability are marked to fair value, but no gain or loss related to that adjustment is included in current period income.

The premium or discount related to the hedge contract is amortized to income over the length of the contract using the effective interest method. For example, if a 100,000 euro foreign currency receivable due in 60 days is recorded at the spot rate of $1.20/euro or $120,000 and at the same date, a forward contract is entered into to deliver 100,000 euros in 60 days at a forward rate of $1.18, the company knows that it will lose $2,000. This $2,000 must be amortized to income over the 60 day period.

19 International Accounting Standards No. 32 and 39 prescribe the accounting for derivatives. Their requirements are similar to SFAS No. 133 and 138 in terms of determining when hedge accounting can be used. The requirements for determining hedge effectiveness are very similar. Both fair value and cash flow hedge definitions and general requirements are similar. However, under IAS 39, firm sale or purchase commitments can be accounted for as either fair value or cash flow hedges which differs from the FASB requirement that they must be accounted for as fair value hedges.

20 A forward contract of an anticipated foreign currency transaction is accounted for as a cash flow hedge. The contract is marked to fair value at each financial date and the corresponding gain or loss is included in other comprehensive income. Any premium or discount must be amortized to income over the contract term using an effective interest rate method. The gain (loss) credit (debit) is offset by a debit (credit) from other comprehensive income.

When the anticipated transaction occurs and the forward contract is settled, the resulting other comprehensive income balance is amortized to income in the same period as the underlying transaction is recognized in income.

SOLUTIONS TO EXERCISES

Solution E12-1

1 b

2 d

3 d

Solution E12-2

1 The dollar has weakened against the yen because it now costs more dollars to buy one yen.

2 10,000,000 yen ( $.0075 = $75,000

|3 |Accounts payable |$75,000 | |

| |Exchange loss | 1,000 | |

| | Cash | |$76,000 |

4 Zimmer would have entered a contract to purchase yen for future receipt.

Solution E12-3

December 16, 2006

| |Inventory |$36,000 | |

| | Accounts payable (euros) | |$36,000 |

To record purchase of merchandise from Wing Corporation for 30,000 euros at $1.20 spot rate.

December 31, 2006

| |Exchange loss |$ 1,500 | |

| | Accounts payable (euros) | |$ 1,500 |

To adjust accounts payable to Wing: ($1.25 - $1.20) ( 30,000 euros.

January 15, 2007

| |Accounts payable (euros) |$37,500 | |

| | Exchange gain | |$ 300 |

| | Cash | | 37,200 |

To record payment of 30,000 euros at $1.24 spot rate in settlement of account payable and to recognize gain.

Solution E12-4

Adjustment in value of account receivable for 2006:

($.84 - $.80) ( 90,000 C$ = $3,600 exchange gain

Adjustment in value of account receivable at settlement in 2007:

($.83 - $.84) ( 90,000 C$ = $900 exchange loss

Solution E12-5

May 1, 2006

| |Accounts receivable (fc) |$333,333 | |

| | Sales | |$333,333 |

To record sale of inventory items to Royal for 200,000 pounds: 200,000 pounds/.6000 pounds (indirect quotation).

May 30, 2006

| |Cash (fc) |$330,579 | |

| |Exchange loss | 2,754 | |

| | Accounts receivable (fc) | |$333,333 |

To record receipt of 200,000 pounds from Royal in settlement of accounts receivable: 200,000 pounds/.6050 pounds.

Solution E12-6 [AICPA adapted]

1

|Receivable at 10/15/06 |$420,000 |

|Euros received and sold for U.S. dollars on 11/16/06 | |

| |415,000 |

|Foreign exchange loss 2006 | 5,000 |

2 On December 31, 2006 Yumi Corp. adjusts its account payable denominated in euros from $12,000 (10,000*.$1.20) to $12,400 (10,000 ( $1.24) and recognizes a loss of $400 [10,000 LCU ( ($1.24 - $1.20)]

|3 | | | |

| | |December 31, 2006 note payable |$240,000 |

| | |July 1, 2007 note payable | 280,000 |

| | |2007 exchange loss |$(40,000) |

| | | | |

|4 | | | |

| | |Note receivable December 31, 2006 |$140,000 |

| | |Amount collected July 1, 2007 | |

| | | (840,000 LCU ( 8) | 105,000 |

| | |2007 exchange loss |$ 35,000 |

Solution E12-7

|1 |Exchange gain or loss in 2006: | |Gain or (Loss) |

| |Account receivable December 16 |$103,500 | |

| |December 31 adjusted balance | | |

| | 150,000 C$ ( $0.68 | 102,000 | $(1,500) |

| |Account payable December 2 |$195,250 | |

| |December 31 adjusted balance | | |

| | 275,000 C$ ( $0.68 | 187,000 | 8,250 |

| |Net exchange gain for 2006 | |$ 6,750 |

| | | | |

|2 |Exchange gain or loss in 2007: | | |

| |Account receivable adjusted 12/31 |$102,000 | |

| |Account receivable 1/15/07 | 101,250 | $ (750) |

| |Account payable adjusted 12/31 |$187,000 | |

| |Account payable 1/30/07 | 188,375 | (1,375) |

| |Net exchange loss for 2007 | | $(2,125) |

Solution E12-8

1 December 12, 2006

| |Inventory |$375,000 | |

| | Accounts payable (yen) | |$375,000 |

Purchase from Toko Company (50,000,000 yen ( $.00750).

December 15, 2006

| |Accounts receivable (pounds) |$ 66,000 | |

| | Sales | |$ 66,000 |

Sale to British Products Company (40,000 pounds ( $1.65).

2 December 31, 2006

| |Exchange loss |$ 5,000 | |

| | Accounts payable (yen) | |$ 5,000 |

To adjust accounts payable denominated in yen for exchange rate change: 50,000,000 yen ( ($.00760 - $.00750).

| |Exchange loss |$ 2,000 | |

| | Accounts receivable (pounds) | |$ 2,000 |

To adjust accounts receivable denominated in pounds for exchange rate change: 40,000 pounds ( ($1.65 - $1.60).

3 January 11, 2007

| |Accounts payable (yen) |$380,000 | |

| |Exchange loss | 2,500 | |

| | Cash | |$382,500 |

To record payment to Toko Company (50,000,000 yen ( $.00765).

January 14, 2007

| |Cash |$ 65,200 | |

| | Accounts receivable (pounds) | |$ 64,000 |

| | Exchange gain | | 1,200 |

To record receipt from British Products Company: 40,000 pounds ( $1.63.

E12-9

1 a. December 1, 2006 No entry is necessary

b. December 31, 2006

| |Other Comprehensive Income (-SE) |$9,901 | |

| | | | |

| | Forward Contract (+L) | |$9,901 |

Forward contract value at 12/31/06($1,000 - $980)*500 = $10,000/(1.005)2= $9,901 liability

c. Settlement date February 28, 2007

| |Forward Contract (-L) |$9,901 | |

| |Forward Contract (+A) | 2,500 | |

| | Other Comprehensive Income (+SE) | |$12,401 |

Forward contract value at 2/28/07($1,000 - $1,005)*500 = $2,500 asset. The forward contract liability at 12/31/06 is eliminated and the asset established. Accordingly, the corresponding credit to other comprehensive income, $12,401, will result in an ending balance of $2,500 credit in other comprehensive income.

| |Rice Inventory ($1,005 * 500) |$502,500 | |

| | Cash | |$502,500 |

To record the rice purchase at market price

| |Cash |$2,500 | |

| | Forward Contract (-A) | |$2,500 |

To record the forward contract settlement

2

| |Cash |$600,000 | |

| | Sales | |$600,000 |

| | | | |

| |Cost of Goods Sold |$500,000 | |

| |Other Comprehensive Income | 2,500 | |

| | Inventory | |$502,500 |

E12-10

1 a. December 1, 2006

No entry is necessary

b. December 31, 2006

| |Loss on forward contract |$9,901 | |

| | Forward Contract | |$9,901 |

Forward contract value at 12/31/06($1,000 - $980)*500 = $10,000/(1.005)2= $9,901 liability

| |Firm Purchase Commitment |$9,901 | |

| | Gain on firm purchase commitment | |$9,901 |

c. Settlement date February 28, 2007

| |Forward Contract |$9,901 | |

| |Forward Contract | 2,500 | |

| | Gain on forward contract | |$12,401 |

Forward contract value at 2/28/07($1,000 - $1,005)*500 = $2,500 asset.

| |Loss on firm purchase commitment |$12,401 | |

| | Firm purchase commitment (-A) | |$9,901 |

| | Firm purchase commitment (+L) | | 2,500 |

| |Rice Inventory |$500,000 | |

| |Firm purchase commitment | 2,500 | |

| | Cash | |$502,500 |

To record the rice purchase at market price

| |Cash |$2,500 | |

| | Forward Contract (-A) | |$2,500 |

To record the forward contract settlement

2.

| |Cash |$600,000 | |

| | Sales | |$600,000 |

| | | | |

| |Cost of Goods Sold |$500,000 | |

| | Inventory | |$500,000 |

Solution E12-11

March 1, 2006

| |Inventory |$16,300 | |

| | Accounts payable (pesos) | |$16,300 |

To record purchase of inventory items denominated in pesos:

100,000 pesos ( $.1630.

Forward contract—no entry is necessary

May 30, 2006

| |Cash (pesos) |$16,000 | |

| |Exchange loss | 500 | |

| | Cash | |$16,500 |

To record receipt of 100,000 pesos from the exchange broker when the exchange rate is $.1600. Exchange loss: 100,000 pesos ( ($.1650 - $.1600).

| |Accounts payable (pesos) |$16,300 | |

| | Cash (pesos) | |$16,000 |

| | Exchange gain | | 300 |

To record payment to Cavilier of 100,000 pesos. Gain: 100,000 pesos ( ($.1630 - $.1600).

Solution E12-12

1 December 1, 2006

| |Inventory |$5,500 | |

| | Accounts Payable (yen) | |$5,500 |

Spot rate is $.00055*10,000,000 = $5,500

No entry is necessary related to the forward contract is necessary at this date.

December 31, 2006

| |Exchange Loss |$100 | |

| | Accounts Payable (yen) | |$100 |

Entry to mark the accounts payable to the spot rate at year-end.

| |Other Comprehensive Income |$100 | |

| | Exchange gain | |$100 |

Amount reclassified out of other comprehensive income in order to offset the exchange loss since this is a cash flow hedge situation.

| |Exchange Loss |$99.10 | |

| | Other comprehensive income | |$99.10 |

The discount resulting from the forward contract is amortized to income over the contract’s term. To solve for the effective interest rate $5,500*(1+r)2= $5,700. $5,700 = the forward rate .00057*10,000,000 = $5,700. Solving for r= 1.80195%. The discount amortization for this is .0180195*$5,500 = $99.10.

Summary: A loss of $99.10 is reflected in 2006 income.

2

January 30, 2007

| |Exchange Loss |$100 | |

| | Accounts Payable | |$100 |

To mark Accounts Payable to spot rate

| |Cash (yen) |$5,700 | |

| | Cash | |$5,700 |

To record receipt of 10,000,000 pesos from the exchange broker.

| |Other Comprehensive Income |$100 | |

| | Exchange Gain | |$100 |

To record payment of cash to the exchange broker.

| |Exchange Loss |$100.90 | |

| | Other Comprehensive Income | |$100.90 |

To record amortization of discount for the last portion of the forward contract’s term.

Summary: A loss of $100.90 is reflected in 2007 income. Notice that the balance in Other Comprehensive Income is now $0. (12/31/06 $100 debit – $99.10 credit = $.90 debit 12/31/06. $.90 debit + 100 debit - $100.90 credit = $0 balance at 1/30/07).

Solution E12-13 [AICPA adapted]

1 Assuming that this is a fair value hedge. At 12/31/06, $3,000 is the forward contract fair value [100,000*($.90 forward rate contracted - $.93 Forward contract rate at 12/31/06) = $3,000].

Since this contract will not be settled for 72 days, the present value of the contract is $2,929 using .03288% [i=12%/365 days] , n=72 and future value of $3,000. The exchange gain related to this contract is recorded at 12/31/06 and the forward contract asset account is debited.

December 31, 2006

| |Forward Contract |$2,929 | |

| | Exchange Gain | |$2,929 |

To record forward contract at market

| |Exchange Loss |$10,000 | |

| | Accounts Payable | |$10,000 |

To mark accounts payable to fair value at 12/31/06 (this assumes that the accounts payable was marked to market on 12/12/06, the date the forward contract was entered into)

2 This firm purchase commitment would be accounted for as a fair value hedge.

December 31, 2006

| |Forward Contract |$2,929 | |

| | Exchange Gain | |$2,929 |

| |Exchange Loss |$2,929 | |

| | Firm purchase commitment | |$2,929 |

3 The forward contract would again be recorded at fair value throughout the life of the contract. Therefore, a $2,929 gain would be reported at 12/31/06.

Solution E12-14

April 1, 2006

| |Contract receivable |$35,250 | |

| | Contract payable (fc) | |$35,250 |

To record forward contract to sell 50,000 Canadian dollars to the exchange broker at the forward rate of .705 for delivery on May 31 for $35,250.

May 31, 2006

| |Cash (fc) |$36,250 | |

| | Sales | |$36,250 |

To record sale of fittings to Windsor for 50,000 Canadian dollars: ($.725 ( 50,000 Canadian)

| |Contract payable (fc) |$35,250 | |

| |Exchange loss on forward contract | 1,000 | |

| | Cash (fc) | |$36,250 |

To record payment of the contract denominated in Canadian dollars to the exchange broker.

| |Cash |$35,250 | |

| | Contract receivable | |$35,250 |

To record receipt of the $35,250 from the exchange broker to settle the account receivable denominated in U.S. dollars.

| |Sales |$ 1,000 | |

| | Exchange loss | |$ 1,000 |

To reclassify exchange loss on forward contract as an adjustment of the selling price.

Alternative solution:

On April 1, 2006, no entry is necessary if the forward contract allowed net settlement. If this is the case, the May 31, 2006 entries would be:

May 31, 2006

| |Cash |$36,250 | |

| | Sales | |$36,250 |

To record sale of fittings to Windsor for 50,000 Canadian dollars: ($.725 ( 50,000 Canadian). Assuming immediate conversion of the Canadian dollars to U.S. dollars at the current exchange rate.

| |Exchange loss on forward contract | 1,000 | |

| | Cash | |$1,000 |

To record net settlement of the exchange contract.

| |Sales |$ 1,000 | |

| | Exchange loss | |$ 1,000 |

To reclassify exchange loss on forward contract as an adjustment of the selling price.

Solution E12-15

1 Entry on November 2 for contract with the exchange broker:

| |Contract receivable (fc) |$ 7,800 | |

| | Contract payable | |$ 7,800 |

To record contract to purchase 1,000,000 yen in 90 days at the future rate.

If this contract allowed for net settlement, then no entry would be necessary on November 2.

2 No journal entry needed as the 30-day future rate at the end of the year is at $.0078 which was the same rate as the 90-day rate on November 2.

Solution E12-16

Comment: The contract receivable and payable are both recorded instead of recording the contract net because Martin must deliver the euros to the exchange broker, net settlement is not allowed.

October 2, 2006

| |Contract receivable |$653,000 | |

| | Contract payable (fc) | |$653,000 |

To record contract to sell 1,000,000 euros to exchange broker in 180 days for the forward rate of $.6530.

December 31, 2006

| |Contract payable (fc) |$ 12,000 | |

| | Exchange gain | |$ 12,000 |

To adjust contract payable in euros to the 90-day forward rate of $.6410.

March 31, 2007

| |Contract payable (fc) |$641,000 | |

| |Exchange loss | 14,000 | |

| | Cash (fc) | |$655,000 |

To record payment of 1,000,000 euros to exchange broker when spot rate is $.6550.

| |Cash |$653,000 | |

| | Contract receivable | |$653,000 |

To record receipt of U.S. dollars from exchange broker in settlement of account.

SOLUTIONS TO PROBLEMS

Solution P12-1

|1, 2 | |Per |Balance |Exchange Gain |

| | | Books  | Sheet  |or (Loss) |

| |Accounts receivable | | | |

| |U.S. dollars |$28,500 |$28,500 | |

| |Swedish Krona (20,000 ( $.66) | 11,800 | 13,200 |$1,400 |

| |British pounds(25,000 ( $1.65) | 41,000 | 41,250 | 250 |

| | |$81,300 |$82,950 | 1,650 |

| |Accounts payable | | | |

| |U.S. dollars |$ 6,850 |$ 6,850 | |

| |Canadian dollars (10,000 ( $.70) | 7,600 | 7,000 |$ 600 |

| |British pounds (15,000 ( $1.65) | 24,450 | 24,750 | (300) |

| | |$38,900 |$38,600 | 300 |

| | Net exchange gain | | |$1,950 |

3 Collect receivables:

| |Cash |$28,500 | |

| | Accounts receivable | |$28,500 |

To record collection of accounts receivable.

| |Cash |$13,400 | |

| | Accounts receivable (Krona) | |$13,200 |

| | Exchange gain | | 200 |

To collect 20,000 Krona at $.67 spot rate.

| |Cash |$40,750 | |

| |Exchange loss | 500 | |

| | Accounts receivable (pounds) | |$41,250 |

To collect 25,000 pounds at $1.63 spot rate.

4 Settlement of accounts payable:

| |Accounts payable |$ 6,850 | |

| | Cash | |$ 6,850 |

To record payment of accounts denominated in dollars.

| |Accounts payable (Canadian $) |$ 7,000 | |

| |Exchange loss | | 100 |

| | Cash | |$ 7,100 |

To record payment of account denominated in Canadian dollars at $.71 spot rate.

| |Accounts payable (pounds) |$24,750 | |

| | Cash | |$24,300 |

| | Exchange gain | | 450 |

To record payment of 15,000 pounds at $1.62 spot rate.

Solution P12-2

|1, 2 | | |Balance |Exchange Gain |

| | |Per Books | Sheet  |or (Loss) |

| | | | | |

| |Accounts receivable | | | |

| |British pounds (100,000 ( 1.660) |$165,000 |$166,000 |$1,000 |

| |Euros (250,000 ( $.670) | 165,000 | 167,500 | 2,500 |

| |Swedish krona (160,000 ( $.640) | 105,600 | 102,400 | (3,200) |

| |Japanese yen (2,000,000 ( $.0076) | 15,000 | 15,200 | 200 |

| | |$450,600 |$451,100 | 500 |

| | | | | |

| |Accounts payable | | | |

| |Canadian dollars(150,000 ( $.69) |$105,000 |$103,500 |$1,500 |

| |Swedish krona (220,000 ( $.135) | 28,600 | 29,700 | (1,100) |

| |Japanese yen (4,500,000 ( $.0076) | 33,300 | 34,200 | (900) |

| | |$166,900 |$167,400 | (500) |

| | | | | |

| | Net exchange gain | | |$ 0 |

3 The company would need to enter into a contract to deliver 250,000 euros (sell them) since it would be receiving euros and would need to convert them into US dollars.

Solution P12-3

1 The purpose of this hedge is to reduce variability in cash flows in the future since the firm entered into a variable interest loan and is swapping that for a fixed interest rate. This is therefore a cash flow hedge.

2 One would expect that this is a highly effective hedge because the notional amount, $400,000 and the length of the term of the swap agreement agree.

3 a. The LIBOR rate at 12/31/06 is 5%, thus 2007’s interest rate on the variable loan will be 5% + 2% = 7%. The swap fixed rate is 8%. Campion will pay .01 percent more than the variable rate. The fair value of the swap is the present value of the estimated future net payments.

|Date of payment |Estimated payment based on |Factor |Present Value |

| |12/31/06 LIBOR rate | | |

|12/31/07 |.01*$400,000 |1/(1.07) |$ 3,738 |

|12/31/08 |.01*$400,000 |1/(1.07)2 | 3,493 |

|12/31/09 |.01*$400,000 |1/(1.07)3 | 3,265 |

|12/31/10 |.01*$400,000 |1/(1.07)4 | 3,051 |

|Total | | |$13,547 |

b.

December 31, 2006

| |Other Comprehensive Income (-SE) |$13,547 | |

| | Interest Rate Swap (+L) | |$13,547 |

To record the fair value of interest rate swap, cash flow hedge at 12/31/06.

| |Interest Expense |$32,000 | |

| | Cash | |$32,000 |

To record interest payment.

4.

December 31, 2007

| |Interest Expense |$28,000 | |

| | Cash | |$ 28,000 |

To record payment to Veneta Bank of the interest expense for the year under the variable rate loan. The rate set on the loan at 1/1/07 was 7%.

| |Interest Expense |$ 4,000 | |

| | Cash | |$ 4,000 |

To record the payment due on the interest rate swap because the fixed rate is 8%. This represents the net settlement amount.

| |Interest rate swap (-L) |$ 8,347 | |

| | Other Comprehensive Income (+SE) | |$ 8,347 |

To record the change in fair value of the interest rate swap.

The new variable rate for 2008 which is set at 12/31/07 is 5.5% + 2%. As a result, the estimated amount that Campion would pay is reduced from 1% to .5%.

|Date of payment |Estimated payment based on |Factor |Present Value |

| |12/31/06 LIBOR rate | | |

|12/31/08 |.005*$400,000 |1/(1.075) |$ 1,860 |

|12/31/09 |.005*$400,000 |1/(1.075)2 | 1,731 |

|12/31/10 |.005*$400,000 |1/(1.075)3 | 1,610 |

|Total | | |$ 5,200 |

The unadjusted Interest Rate Swap liability is $13,547 credit, the adjusted is $5,200 credit, the Interest Rate Swap Liability must be reduced by $8,347.

Solution P12-4

1. This is a fair value hedge because the fixed rate loan’s fair value fluctuates over time as market interest rates change. By entering into this swap agreement that fluctuation is eliminated. So while the interest rate fluctuates, the loan’s fair value remains constant reflecting the fixed rate in the swap.

2. Like P12-3, the terms match, thus this is considered to be a highly effective hedge.

3.

a.

|Date of payment |Estimated payment based on |Factor |Present Value |

| |12/31/06 LIBOR rate | | |

|12/31/07 |.01*$400,000 |1/(1.09) |$ 3,670 |

|12/31/08 |.01*$400,000 |1/(1.09)2 | 3,367 |

|12/31/09 |.01*$400,000 |1/(1.09)3 | 3,089 |

|12/31/10 |.01*$400,000 |1/(1.09)4 | 2,834 |

|Total | | |$12,960 |

b. December 31, 2006

| |Interest Expense |$32,000 | |

| | Cash | |$32,000 |

To record interest due on fixed rate loan at 12/31/06

| |Loan Payable (-L) |$12,960 | |

| | Interest Rate Swap | |$12,960 |

To record the interest rate swap at fair value, computations below.

Notice that the carrying value of the loan is now $387,040 ($400,000 - $12,960). This agrees with the present value of the loan at the market rate of 9%.

Proof: $400,000/(1.09)4 = $283,370 ................
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